Friday, November 30, 2007

Crash or Malaise?

If we take as our starting point that global excesses are in the process of unwinding, then the Big Question is: will it come apart in a crash, or degrade in a decade of malaise?

We have an example of each in the 20th century: the 1929 Crash and Great Depression (a deflationary collapse of a huge credit bubble) and the "stagflation" of the 70s (stagnation of wages, growth and profits in an inflationary spiral). Here are the charts of the stock market in those time frames:

Here we see that once the "echo bubble" burst in 1937, the market--and the economy--noodled around in a downtrend until the U.S. mobilized for World War II. Some features of this era seem similar to our own: a wild expansion of credit and speculative fever, and the bursting of that excess in a long, painful deflationary decline in which goods and services cost less every year.

The market climbed from 1932 to 1937 on the hope that "everything is back to normal." But of course it wasn't; the structural damage had yet to fully play out.

As the line indicates, the echo-bubble crashed about 7.5 years after the market broke down. If we take the March 2000 market top as the analog, then we have to note that the October 2007 Dow Jones high is the analogous "echo-bubble top." Hmm.

This deflation also bears similarities to Japan's "Lost Decade" (more like 17 years and running) after its stock and real estate bubbles burst in 1990. In a very real way, Japan has yet to extract itself from that deflationary spiral, even though it has borrowed and spent trillions in public "prime the pump" spending and kept government bond rates at the absurd level of .50% (one-half percent).

This is a chart of alternating hope and despair. As structural problems sapped the economy and inflation gained, the market swung every few years from hope to despair, tracing volatile highs and lows of 40%. By the time the "decade of malaise" Bear market finally ended in 1982, $1 in 1966 had plummeted due to inflation to a mere 34 cents.

Meaning that when the DJIA finally reached 1,000 again in 1982, those who had held onto their stocks during the Bear's 16 year reign (from 1966 to 1982) had lost 2/3 of their investment. (If the stocks paid a dividend, then the loss might have been cut to 50% - 60%.)

So what will the next 10-16 years look like for us? 1937, 1977 or something completely different?

As I described yesterday, the interconnectedness of the global economy has grown into a web of dependencies that far exceeds the oil exporter/consumer nexus established in the 1970s. International players who have never heard of the Trilateral Commission or The Plunge Protection Team are busy working their own Plunge Protection Teams--all of which depend on a healthy U.S. economy.

Even our so-called "foes"--Venezuela, Iran and Russia--are all dependent on a robust global appetite for oil and natural gas. If the U.S. --fully 25% of the global GDP and consumer of 25% of the world's petroleum products--slides into a deep recession, then the dominoes of Asia and Europe topple, too, reducing global demand for oil and creating a glut of supply which will cut earnings of Iran, venezuela and Russia--perhaps severely.

Recall the negative feedback loop of falling oil prices. As the price per barrel falls, governments which depend on oil revenues to placate their populations and fund their governments and militaries are in a terrible bind; they are spending every dime they get from oil, and can't afford to trim their budgets lest the citizenry and those feeding at the public trough become restive.

So what do they do? Pump more oil to compensate for the lower price per barrel, which quickly exacerbates the oversupply, dropping the price ever lower. This feedback loop powered the 1997-98 drop in oil from above $30 to about $10--a catastrophic reduction in income for all oil-exporting nations.

So what's different now? The world will try mightily to prop up an ailing U.S. economy. This argues not for a crash but for a 1970s-style decade of back-and-forth hope and gloom as the structural problems of the U.S. economy--unaffordable entitlements, widening deficits, crippled banking sector, debt-burdened consumers, sagging domestic profits, declining housing values, etc.--cause declines which are countered by "solutions" like lower interest rates, non-U.S. infusions of cash, etc.

As Mish has so ably described, overburdened borrowers won't be able to borrow more, no matter how enticing the rates. And we are already seeing the non-U.S. infusions of capital coming--first with Citicorp, but why not Countrywide or a dozen other ailing lenders?

Foreign investment in the U.S. is nothing new, of course. The U.K. remains one of the biggest owners of U.S. assets, and one of the astute Saudi princes bought 5% of Citicorp back in the 80s when it was trading for $5. He also bought a big chunk of Apple Computer when that firm's shares traded around $12/share in the mid-90s. The Japanese went on a real estate buying spree in the late 80s which drove up the price of real estate in Honolulu, Los Angeles and New York.

Although foreign ownership sparks occasional handwringing and/or outrage, it has a long history. Yes, we can't allow strategic military assets Boeing or Lockheed or Intel to pass into foreign control, but Citicorp? Take the whole thing, please! If investors from Gulf oil exporting nations or China end up owning Citicorp, WAMU and Countrywide, what's the big deal? Maybe they'll demand some fiscal discipline and sound stewardship.

So then the question becomes: can lower interest rates and foreign capital "fix" the structural problems rotting the core of the U.S. economy? Of course not. That's where the malaise comes in: structural deficits, global wage arbitration, a broken medical care system, a Medicare growing by 10% a year as the economy which supports it grows at 2%, a complete lack of forward-looking energy policy, a money-pit war without end, and so on.

The crystal ball is cloudy, cloudy, I see only shapes, images, tendrils--but I do see one word that glows darkly through the mist: malaise. And if history is any guide, then the year 2016 looms as the earliest point when things could truly turn around. The cycles are long, and it is too far ahead to see with much precision, but we do know that, once enthroned, the Bear has reigned for 16-17 years. .

Thank you, Greg R., ($19.29), for your generous and numerically significant contribution to this humble site. I am greatly honored by your readership and support. All contributors are listed below in acknowledgement of my gratitude.

Wednesday, November 28, 2007

I'd like to introduce a new housing journal for homeowners of shoddily constructed McMansions(see below):

Don't get me wrong: I'm not making light of the problems faced by many owners of slapped-together bubble-era homes. I am simply noting the potential problems I see as a former builder.

1. Modern materials are vulnerable to rapid failure if improperly installed. If you've owned old houses--and by that I mean 50 years or older--you've probably seen how ordinary solid wood holds up to quite a bit of abuse. You would be hard-pressed to seriously damage solid 3/4-inch oak flooring, which was common even in inexpensive houses and apartments up through the early 1950s.

Not so modern-day thin veneer "hardwood flooring." Delamination, faulty installation, animal urine, water damage, deep scratches--any of these can spell the end of modern veneer. The same vulnerabilities to faulty installation and damage are present in brick or stone veneers as well as veneer siding and cabinetry.

While the lumber industry has shown that "engineered materials" like wafer-board (such as OSB, oriented strand board) are strong, the long-term durability of glue-and-wood-chips is still an open question. Judging by what happens to chip-board and wafer-board that's been left out in the weather, you have to wonder how well these products hold up once water is present.

2. This means modern homes are especially vulnerable to poor workmanship. In the old days of tar paper and solid wood siding or thickly-applied plaster, the robustness of the basic materials often compensated for small flaws in the workmanship.

In an old sash window, layers of solid material worked to keep rainwater from leaking into the wall. Modern waterproofing like Tyvec works extremely well when properly installed, but the flimsiness and vulnerabilities of the modern siding or stucco exteriors don't provide much protection. If the stucco or pressed-wood siding is installed poorly, the Tyvek better be perfect--or the house will leak.

Whereas solid wood and thick plaster are water-resistant (yes, they will suffer damage from permanent water presence via plumbing leaks and the like), modern materials like gypsum board and particle board are essentially sponges. Leaks get soaked up and held inside insulated walls where molds and dryrot can flourish undetected.

3. In boom times, demand outstrips the available supply of qualified craftspeople. Unqualified workers make large numbers of critical mistakes. It's just a fact of life that it takes years of training and field experience to become a good carpenter, sheetmetal fabricator, etc.

Unfortunately, the tasks most likely to be rushed by neophytes, such as window and door flashing, are precisely the points which invite water leaks. Water is the mortal enemy of every structure, and leaks around windows can end up costing thousands of dollars in damage. It's not that unusual nowadays to see entire apartment or condo projects or groups of houses covered with schaffolding as crews remove all the windows and re-install new windows and trim--probably with greater care than the original builders.

4. People in a hurry don't have time to be careful. When millions of homes were being built as fast as possible, every contractor was feeling the pressure to "hurry up." That mentality leads the sitework/grading contractor to rush the soil compaction, which means heavy rains a few years later may undermine somebody's garage, which soon slides into the gully.

The plumber doesn't have time to check the work of his new employees, so mistakes may not be caught. Harried, overworked building inspectors are under pressure to approve dozens or hundreds of new homes; did they all have enough time to do a thorough inspection? Many undoubtedly worked on reputation; "this guy's work has been good in the past so a walkthrough is enough."

In pre-boom times, the guy's work was good; but now he has green/inexperienced crews and subcontractors he doesn't even know.

5. "Sure, I can do that." Everybody wants to get in on the action during a housing boom, and plenty of guys will claim carpentry and other trade skills they don't really possess. In other words, there is a construction analogy to the "no-document" mortgages: people who claim to be qualified but aren't. And just like the loan officers getting paid to process loans as fast as possible, builders had little incentive to monitor every new employee's work quality. The incentives were all on speed of production.

All of these macro-factors created the potential for construction flaws which lead to serious failure/damage.

In other words, there may be more damage in a three-year old poorly-built home of modern materials than in a 30-year old house constructed of durable materials by competent craft workers.

Sure, modern houses are durable--if they're carefully built. But modern materials are not very forgiving of poor workmanship, and I fear we haven't even begun to grasp the full scale of omissions and errors built into thousands of hurriedly constructed McMansions.

Thank you, Ken M., ($20), for your second generous contribution to this humble site. I am greatly honored by your readership and support. All contributors are listed below in acknowledgement of my gratitude.

Tuesday, November 27, 2007

Astute reader Ken K. sent in this wonderful insight into investors and speculators:

My grandfather always said an investor was a speculator who made a mistake and wouldn't admit it!

Which brings us to the looming question: just who is going to absorb all the losses coming to light as banks and other institutions admit their speculations have soured? In pure capitalism, the answer is obvious: those who took the risk in hopes of earning the return must suffer the loss.

But in statist capitalism (i.e. the U.S.), huge private losses have been absorbed by the public--most directly, in the late 80s when the savings and loan debacle was "cleaned up" with $150 billion in taxpayer money.

So perhaps the real credo of our "statist capitalism" is: the profits are private, but the losses are public.

Knowledgeable reader Zeus Y. made the following thoughtful comments on this issue:

"Do I think the U.S. economy is healthy? Heck no, but again, in my own idiosyncratic view, markets are not connected to reality. They are only connected to the emotions and views of the investors/speculators." (CHS, November 26)

I agree, and I think it might be helpful to add the dimension of personal power over the market, especially in how personal power disproportionately exercised in the market can augment and magnify emotions and views. Just as our elections are much closer to "one dollar, one vote" than "one person, one vote," so are the prejudices, interests, and emotions of some market players much more consequential and powerful in the market than others.

This has a way of intensifying the warping of market "reality" (how things should work in theory if there is basic equality between investors in a market and/or voters in a democracy). Basic theories assume all investors or voters can access the same information, equally execute choices given that information, and experience proportional consequences.

Both in our markets and in our democracy these basic assumptions have become unglued, and this tends to destroy the ability of democracy or the market system to buffer irrational excesses. People do not have access to the same information. From the Bush administration’s ability to use "national security" to lock out scrutiny to market insider trading, there is no equality or transparency of information.

Not all "voters" in a democracy or investors in a market have the same power execute choices. Witness the disproportionate power claimed by the executive branch in the US government (especially under a state of perpetual war) to trump the legislative branch, and the power of mutual and hedge fund managers to trump the vast majority of stock holders when it comes to decisions over how companies should be run.

Finally we are seeing that the economically privileged are allowed to have their way in the markets, harvest profits on questionable ventures, and when they screw it up, slide the consequences on to the taxpayer in terms of bailouts. The motto seems to be: "Use manipulative tricks to rally the market (buying one’s own stock to create false demand, etc.) to eke out yet another multi-hundred million dollar year-end bonus before everything blows. Get a 100-200 million dollar golden parachute after everything blows." Nothing succeeds like fake success and failure.

You look at how George Bush simply decided to issue "signing statements" saying he wasn’t going to execute the law if he didn’t like what it says. You look at how the Bush administration has used the veto and a craven minority to prevent the will of the people from going forward with regard to the Iraq War. You look at the extreme manipulation of the election system in 2000, 2002, and 2004 and of the political patronage system to reward incompetent yes-men and fire wise counsel.

And then when the awful consequences of these policies and actions come due, and our reputation as a country is shattered, our middle class is demolished, national debt has tripled, and the US dollar is in the toilet, the self-same individuals who started this mess indicate that this is a reason to give them "emergency" power to do more of the same.

Something similar is happening in the market. We’ve already seen how banks, hedge fund managers, mortgage agencies, and ratings agencies like Moody’s colluded to pass off junk as AAA rated securities. This has led to a collapse in real value of purportedly solid investments, based on outright fraud. Yet no criminal or civil penalties are in the offing.

You have the collapse of government and corporation into one another. You have the complete privatization of markets (look at private equities buying up public companies with funny money), just as you have a nearly complete privatization of government, not only in terms of eliminating public jobs but in eliminating public benefit.

And this is seen as "good" by those who have benefited immensely from their own vastly outsized personal power to sway supposedly impersonal governmental and market mechanisms, including Mr. Dick Cheney, who has taken advantage of both arenas to package together governmental war policy with Halliburton’s private war profiteering.

It is not surprising in a system that has devolved so badly to see the Federal Reserve, itself a private corporation, essentially dictating that the US taxpayer absorb the losses from this shell game and even reward multinational banks and equity/fund traders for their malfeasance.

Of course, it is also crushing to witness the end of innocence of your country, but also heartening to realize, the game is really afoot now. Are we going to answer the call and take back our democracy, run for office ourselves, elect progressives, refuse to buy into these scams, and demand accountability and integrity, or are we going to roll over? We are not staring at a possible oligarchy, but we are undeniably witnessing, what has been since the election of Reagan, the evolution and culmination of almost 30 years of oligarchic rule (not coincidentally linked directly with debt-driven "growth") aimed at the privatization of all public benefit and the public absorption of all private risk.

Now it is time to act. I’ve never been a pessimist or even a cranky realist. I believe in the entrepreneurial and innovative democratic spirit this country has exhibited in its best times can rise yet again, if we act critically and creatively to reassert the power of the people in the market and in democracy.

In the spirit of civic democracy and in the conviction that markets will once again be free and public,Zeus Y.

Put another way--the profits are mine but the losses are "ours" (i.e. yours). Thank you, Zeus, for this cogent analysis.

Thank you, Jerry and Rosanne A.., ($21), for your thoughtful contribution to this humble site. I am greatly honored by your readership and support. All contributors are listed below in acknowledgement of my gratitude.

Monday, November 26, 2007

Speculator or Investor? Does It Matter?

Speculator bad, investor good. That at least is the cliche. The investor, we are told, invests in solid companies or bonds for the long-term dividends and appreciation, refusing to churn his or her money with constant buying and selling. The penultimate investor is Warren Buffett, who famously buys and holds stocks for decades, and who also famously eschewed speculating in tech stocks during the go-go 1990s dot-com bubble.

But Buffett also speculates--that is, buys positions not for decades but for months or a few years. He has speculated on the dollar and recently dumped his position in one of China's national oil companies which he'd established a few short years ago.

If a speculator bets on the price of silver or oil or the dollar, are they really doing the work of the Devil? Interestingly, rich folks are allowed to put their money in quant funds and hedge funds, both of which churn the money through whatever markets offer the best return: in other words, pure, unadulterated speculation.

So is the real difference between the investor and the speculator is the wealthy get to place their money with professional speculators, while us working stiffs/debt serfs are corralled into "buy and hold" (and historically low return) investments?

There is another angle, of course, to speculation versus investment; the speculator may be short the market (betting a market declines), and may also be using borrowed or leveraged money--in other words, playing with a much higher level of risk than the "buy and hold" investor.

On the other hand, the "buy and hold" investor who bought Cisco Systems for $81 in early 2000 has lost 3/4 of their money, once inflation is factored in. Was buying and holding CSCO a lower-risk bet than short-term speculation? Perhaps in the sense that it was unlikely to drop to zero, but from peak to trough it did decline by almost 90%. Was this a significantly lower risk than the purest short-term speculation? Perhaps, but perhaps not; maybe the "buy and hold" investor invites as much or even more risk than the prudent speculator.

Maybe lambasting speculators is a form of envy; we too would love those fat returns. Put another way: if a regular, non-elite stiff manages to speculate successfully and make a few bucks to offset his/her shrinking paycheck and buying power, then shouldn't that person be applauded for offsetting his/her declining purchasing power via wise money management?

I wrote this past weekend on the unparalleled opportunity our society offers; and one opportunity is the open market in currency, commodities, stocks, bonds and futures/options. Yes, failure and loss are part of any market; there are no guarantees of success or profit. If there were, then we'd all be billionaires.

With that said, let's look at a chart of the Dow Jones Industrial Average. As a personal opinion, not as investment advice, it seems to me that the bad news may be setting up a Bull Run to the end of the year. Yes, the economy is sliding into recession, but so what? The institutional money managers need to get a good green "up for the year" rally going, and perhaps we should look at what the pros are doing. (Recall that the Market is never truly tethered to economic reality.)

In the contrarian view, since the news has been uniformily bad for weeks, the market may be poised to rally huge. Maybe, maybe not; the market rarely conforms to the majority expectation.

With that in mind, let's look at oil, that favorite of both investors and speculators alike. Here is a chart of the USO ETF (exchange traded fund) which tracks the price of crude oil.

There are technical hints here--for one, a decline/divergence in the MACD even as price continued climbing--which suggest oil's leap to $100 is sputtering. If traders/investors believe oil is about to shoot beyond $100 to, say, $120, we'd expect to see them buying up oil producers, like Anadarko Petroleum.

But as this chart reveals, APC has dropped from its recent high even as oil has continued rising. That suggests buyers aren't quite as confident in oil's continued rise as they were earlier.

Disclosure: just so there are no undisclosed positions, I should note that in mid-August I bought call options on APC, betting it would rise, which returned a nice profit as APC rose. Now I own put options, or bets that APC will decline in the month ahead.

Just to reiterate: this is personal opinion, not investment advice. See HUGE GIANT BIG FAT DISCLAIMER below. One of my interests is the stock market, and so I jot down personal views on it from time to time, always disclosing any positions I might have in securities I mention.

Do I think the U.S. economy is healthy? Heck no, but again, in my own idiosyncratic view, markets are not connected to reality. They are only connected to the emotions and views of the investors/speculators.

Thank you, Stephen T., ($20), for your thoughtful contribution to this humble site. I am greatly honored by your readership and support. All contributors are listed below in acknowledgement of my gratitude.

Wednesday, November 21, 2007

Thanksgiving Essay: In Praise of Average

What am I thankful for? In addition to having enough food, relative safety, loved ones and health, I am happy to be average.

In a culture obsessed with prestige, status symbols and "being special" (only the VIP line for you!), praising the utterly average might seem odd or perhaps ironic in a snickering way. But I am quite serious.

If you're below-average, i.e. mediocre, as I am, then reaching average feels great.

Studies have shown that most of us over-estimate our superiority in any field of endeavor. I undoubtedly did so when I was younger but the hard flinty wisdom of experience has revealed that I am actually decidedly worse than average in the things I have enjoyed and pursued, i.e. sports, carpentry, writing, music, martial arts and stock trading.

In five years of playing team sports (mostly basketball, but a year of football and track thrown in for flavor) I can count the games in which I was a bit better than mediocre on one hand. This, despite endless hours of free throws and shooting baskets after regular practice and in the off season. Football (featherweight benchwarmer) and track (too slow for sprints, no endurance for long races, hopeless at hurdles) were even more ludicrously obvious proofs of "worst on the team, if not in the entire school."

As for music--despite playing a bit of guitar for 30+ years, any teenager who picks up a guitar for six months can easily blow the doors off my playing. As for writing, it only took 20 years to reach average, by which I mean my first novel was published (after 20 years of unstinting effort to become a better writer) to yawns, as are most first novels by unknowns. To say it is average is actually quite a compliment.

As for trading stocks--I am a catastrophically poor trader, hard-wired with a trader's worst traits--impatience, impulsiveness, and all the rest--to make all the same dumb mistakes again and again.

If I continue my three decades of slow improvement as a carpenter, by the time I'm 90 or so I might be pretty good--if I can still pick up a 2-by-4. Martial arts? Fortunately I have a great tolerance for being repeatedly humiliated.

Though I try to be understanding and generous, the truth is I am at best average in the "saintly human being" category as well. I remain a student in all things, acutely aware of my shortcomings and hoping to improve up to average--which is actually pretty darn high. Many people are whip-smart, kind, reliable, generous--the bar of "average" is high.

So in other words, just clawing your way up to average is something to be thankful for when you're below average.

Here's something else to be thankful for:

All human societies are focused on social standing, for high status and wealth attracts the best potential mates and raise the odds that one's offspring will survive and perhaps prosper.

Nonetheless, it seems American culture has slipped into a state of anxious insecurity in which failure to qualify for an elite university justifies cheating, and failure to reach the highest level of sports justifies, nay, almost requires, cheating via doping and drugs.

Why do I say this is deeply insecure? If an individual is secure in their abilities, they don't fear the consequences of not getting into Yale, etc., or not being hired by Goldman Sachs or not reaching the heights of the NFL. It is the insecure individual who feels lost without an institutional sponsor of their worth, who deep down fears he or she will be nothing without the thick battlements of a revered institution for protection.

Is this deep insecurity a nearly subconscious awareness that the position of non-elite individuals in the nation is increasingly precarious? Perhaps. Perhaps it is also a reflection of a loss of confidence, a pervasive fear that merely being ordinary is to be doomed to a life without wealth and prestige--as if those characteristics are all that give the narrative of our lives meaning.

And so children and already-famous sports stars alike throw away personal integrity-- being interior and not quantified like grades or institutional standing, integrity is obviously worthless in the sprint for prestige and wealth--in order to raise their chances via cheating.

Cheating and stealing have long histories in the animal world, and in primates, so our predilection for cheating and "getting something for nothing" is no surprise; it is to be expected. But should a society accept this behavior with a yawn, or a wink, as if to say, "Just don't get caught?"

I fear that is precisely where American culture has landed--or should I say, run aground.

It's really OK to be average, or even less-than-average, as in dumb, slow, no good, untalented. Why? Because if you manage through discipline and effort to work up to average fitness, or playing a somewhat challenging piece of music or managing your own portfolio with average success, you will have achieved far more than the talent-blessed individual or child of the elite who achieves success or accomplishment without great discipline and effort--and without an appreciation, all too often, for the inner wealth of integrity and compassion.

I look around our prestige-and-wealth obsessed culture, and I don't see a happy people; I see people who can't sleep, people who nervously seek distraction every waking moment via the TV, IM, cellphones or the Web, people who have taken risks and sunk their souls into constructing a facade of "I've made it."

If you have made it (whatever that may be), shouldn't you be able to sleep without wolfing down drugs? Shouldn't you be able to enjoy your success (again, whatever that may be) without an angst that requires more drugs, legal and illegal, just to suppress the demons?

And what are those demons? Of being unwealthy and unprestigious, i.e. just average? Of not having a (fake or real, no difference) Rolex on our wrist? Given the unhappiness rampant among those who have wealth and prestige, we should be wondering if "average" or even "below-average" is the better, happier, integrity-rich place to be. For even if we cannot be guaranteed material security, we can be guaranteed inner security, for we nurture and control that ourselves.

I am also grateful for you, readers, who have taught me so much this year. I hope each of you has a holiday filled with blessings, love and good cheer. (Hey, that rhymes!)

Thank you, Peter K., ($50), for your very generous contribution to this humble site. I am greatly honored by your readership and support. All contributors are listed below in acknowledgement of my gratitude.

Tuesday, November 20, 2007

A disturbing number of mainstream media stories are documenting the appearance of inner-city plagues such as gangs, drugs and graffiti in what were recently middle-class suburbs. Long-time correspondents UKC. and Riley T. checked in with commentaries on the trends of de-gentrifation and wealth destruction. Here are UKC's comments:

"Remember how (many months ago) we were discussing how the some of the suburbs and exurbs might be hit harder by the housing downturn than others? The idea was that the empty houses would not be evenly distributed but would tend to accumulate in sink neighbourhoods. This means you could have a fully paid for house and still see its value reduced to zero as the area becomes unliveable. (emphasis added) You did a post on this. Well, its happening, here's a link I came across:

This site's archives are chockful of entries on the housing bubble, going back to mid-2005 when this blog was launched. Just click on the "archives" links below and scroll right to the topic heading "Housing Bubble Watch."

The main drivers of de-gentrification, of course, are mortgages re-setting higher and falling prices, which reduce equity to a negative number. This removes the incentives (building wealth) which tend to keep homeowners at the debt wheel.

Though various analyses of home equity have been made, Riley T.'s has the merit of considering those homes owned free and clear:

"The debt side of the real estate market has been getting a lot of ink. I thought a look at the asset side might be an eye opener.

Who is going to eat this? The banks are the only ones left. Now if you consider the loss of equity in the commercial real estate, stocks, bonds etc., we are talking about some real money here. So what is anyone in Washington afraid of??

How many homeowners will pay the mortgage on a home that is 20-50 per cent upside down, even if they had the money?

1. Any analysis of home owner equity is a farce without pulling out the homes owned outright. (about one-third).

2. Other analyses continue to mention that the homes with no mortgage are of lesser value then homes with mortgages. They don't mention that the higher value homes tend to dropa larger percentage when prices fall."

Given the forces at work and the evidence trickling in from the real world, I wonder if the Pareto Principle isn't at work here. If so, perhaps we can posit a quantitative model of de-gentrification:

1. When 20% of the homes in a neighborhood have negative equity, then prices begin falling rapidly.

2. When 20% of the mortgages in a neighborhood of rising negative equity re-set higher, then foreclosures rise rapidly.

3. Once 20% of the homes in a neighborhood are distressed, abandoned or foreclosed, then de-gentrification accelerates rapidly.

4. Should a critical inflection point (tipping point) be reached, the remaining responsible homeowners abandon the neighborhood to the forces of de-gentrification.

This process can be illustrated by a chart such as this:

De-gentrification is a highly disturbing possibility in neighborhoods with high numbers of distressed/foreclosed homes. Though I cannot locate any data on this topic, perhaps an academic researcher will be able to gather data and estimate the tipping points.

Anthropological and sociological studies suggest populations begin shifting after relatively small changes in their demographics. These changes tend to gather momentum at certain points. With no other data or studies to go on, I would reckon homeowners' associations would be wise to draw a line in the sand at 20%--in other words, not allow more than 20% of a neighborhood's homes to degrade into abandoned, vandalized eyesores.

How can neighbors stop this decline if they're not the owners? Simple: stop relying on the owners (the owner/lender could be mired in bankruptcy court for years, or be an overseas financial institution with no local office) and mow the lawn and care for the house themselves. Find decent tenants and then pressure the city for services. If the owner cannot be located (bankruptcy court is not an address), then getting someone responsible to occupy the property is a much better strategy than letting criminals and vandals take over the neighborhood one house at a time.

As UKC pointed out, owners who do nothing and let their neighborhood dissolve around them may well find they have no equity left, despite their mortgage being paid off.

Thank you, Gary I., ($20), for your generous contribution to this humble site. I am greatly honored by your readership and encouragement. All contributors are listed below in acknowledgement of my gratitude.

Monday, November 19, 2007

A Power Not To Be Denied: Santa Claus

There are some forces in the galaxy you don't want to challenge, and one of them is Santa Claus, as in "Santa Claus Rally." It is a ripe old Wall Street cliche that come November and December, the market rallies just as surely as children gather round the Christmas tree (or equivalent).

To illustrate the possibility that this cliche has some merit, at least recently, I prepared this chart:

Well gosh darn it, at least in the past few years, Santa Claus has come very reliably to Wall Street. This seems to be true even in low-volatility years bound in long-term trading ranges.

Even though MACD is trending down right now, we note that MACD was also trending down in 2004--yet Santa Claus delivered a rally anyway.

Supporting Saint Nick's possible delivery of a powerful uptrend through the first week of January is the fact that the DJIA has just bounced off the Bollinger bands and the long-term 50-day moving averages.

One highly astute reader has repeatedly called my attention to the fact that fund and institutional investors have a strong incentive to juice the market at the end of every quarter so their performance is improved by quarter's end. And how much more important for one's calendar year performance to rise up by December 31.

Another explanation given for Santa's largesse into January is the massive flood of 401K and IRA retirement money flowing into mutual funds' waiting hands--some of which is often promptly put to work goosing the market higher.

Is this advice? No, just hearsay and personal opinion. Santa could always deliver a load of coal to Wall Street which, in a year of astoundingly insane risks gone bad and stuffed under the bulging carpet, richly deserves it.

Nonetheless, the Santa Claus Rally is a multi-year trend with a significant pedigree.

Since I wrote about "returning to averages" on Friday, frequent contributor Harun I. was kind enough to forward several charts of the Dow Jones Industrial Average from 1900 to the present which illustrate the point I was trying to make much better than my graph by displaying Standard Error Channel trendlines over actual price data. Here are Harun's comments about Standard Error Channels:

I am sure that you understand the concept of regression analysis. The Standard Error Channel has at its core a linear regression line.

Since I wasn't sure I understood, I went to this Wikipedia entry for help: regression analysis.

Here is Harun's first chart and his commentary:

Just to return to the top of the channel, or the lower line of the recent channel, the DJIA would need to decline to 10,000. A move to the regression line would require a move down to 5,000, and a test of the lower channel would take it, as Harun noted, to about 1,000.

If this strikes you as impossible, recall that no one predicted the Nasdaq would fall from 5,000 to 1,100 in less than three years, or that in 1929 (as Harun observed) that the DJIA was about to start a slide which would eventually erase 90% of its value.

In the second chart, the red channel is drawn from the 1932 low to the present highs, and the blue channel is drawn from 1900 to the 2002 market low.

Even with this revised channel, the DJIA would have to decline to 11,000 to reach the top channel, 7,000 to drop back to the regression line and 2,500 to the lower channel. Whatever channel you draw, it's clear the U.S. stock market has risen far above long-term regression channels. As someone who thinks in terms of standard deviations, a standard deviation of 3 suggests a very high probability of a reversion to the mean, another way of saying probabilities favor a huge decline.

Does any of this negate a Santa Claus rally? Not at all, for a Santa Claus rally occurs over the course of a few weeks, while the long-term trends occur over the course of years and even decades.

Recall that the DJIA has equaled an ounce of gold at Bear Market bottoms such as 1982 (i.e. 800 on the DJIA and $800/ounce for gold). Could gold rise to $2,500/ounce and the DJIA decline to 2,500? Perhaps the question should be: why not?

Thank you, Don E., ($10), for your on-going and very generous contribution to this humble site. I am greatly honored by your readership and commentaries. All contributors are listed below in acknowledgement of my gratitude.

Friday, November 16, 2007

Changing Tides V: A Return to Average

What is an "average return"? As the Dow Jones Industrial Average (DJIA) has risen from 3,000 to 14,000 in a relatively short period of time, as house prices doubled and even tripled in a few years, and as gold has rocketed from $300 to $800, have we adjusted "average returns" up to a historically unsupportable expectation?

Just to illustrate the possibility that the recent past may be anything but "average," I prepared this chart: (see below)

Perhaps we can constructively apply the Pareto Principle here and propose that the recent past constituted only 20% of recent history but generated 80% of the investment returns. If this is the case, then not only have these outsized gains skewed long-term returns to the upside, the "average returns" of the past 12 years are not at all average but greatly above the norm (average).

In the long view, it may be that this spike in virtually all assets--real estate, stocks, bonds and precious metals--is not "the new average" but a brief anomaly. For more on this possibility, please see my previous entry The Long Cycles of Prosperity, Decline and Upheaval (July 11, 2007)

If these two concepts are indeed at work, then we can expect a mirror-image of the huge outsized gains on the downside--that is, a period of extremely below-average returns. After markets drop back to where they would have been without a gigantic asset bubble, then perhaps they will resume historically average returns.

If we look at current history through the lens of the Kondratieff cycle (described in the essay link below), we discern the possibility that a long cycle of prosperity and decline might bottom around 2015 - 2020. For more on this line of inquiry, please see the previous entry Are We Poised on the Precipice of Another Age of Turmoil? (June 6, 2005)

What could cause such a capitulation of all asset prices and repudiation of debt? We could start by listing the structural problems which are being ineffectually papered over but which will have to be dealt with at some point:

1. Unaffordable entitlements. I have covered this ad nauseum, but Medicare and Social Security are simply not affordable--and neither are the public pensions promised to government employees.

2. Medical "care" as currently provided is exploding in cost even as its efficacy declines. This is a big part of why entitlements will have to be renounced; medical "care" (quotes communciate the fact that it is often not beneficial, but simply expensive) costs are increasing rapidly even as the positive results (better health, longer lives) become ever smaller.

3. The world's currencies are in declines which could end in a death-spiral of complete worthlessness. Judged by their purchasing power of gold, the world's currencies have already suffered catastrophic declines. (More on that next week.) If fiat money decreases in buying power, everyone paid in fiat money becomes progressively poorer.

4. Peak oil, water and food. As oil, soil and fresh water supplies are depleted, scarcity could become the norm, and costs of those essentials could rise to the point that most global consumers would have little money for anything but those essentials.

5. Debt costs crush consumers and governments alike. Should the cost of money rise, or lending dry up, then the stupendous debts taken on by consumers and governments alike in the past 15 years of "prosperity" will become too burdensome to carry. Debt will be repudiated on a massive scale.

6. Assets decline in value, eliminating borrowing power. If asset bubbles deflate, consumers will have less and less assets to borrow against, creating a deflationary feedback loop in which assets find fewer and fewer buyers even as the price declines accelerate.

7. "Asset wars" smoulder and ignite. If oil, water and food do indeed become scarce on a planetary scale then past human history suggests the probabilities for conflict rise.

8. Environmental degradation. Crop failures, extremes of weather, rising sea levels and drought (not to mention a virulent virus such as bird flu) could trigger social, political and military turmoil within and between nations.

I may have missed one or two, but these structural problems are certainly sufficient to cause an eventual asset/currency capitulation and debt renunciation.

Technical note: the curve-sets on the chart above are of the Nasdaq stock market for the years 1974-2007. I used this chart to suggest how asset bubbles can pop and revert to the mean. This particular asset spike was the dot-com tech-stock bubble.

Thank you, Cudick A., ($25), for your generous contribution to this humble site. I am greatly honored by your readership and support. All contributors are listed below in acknowledgement of my gratitude.

At first glance, this sure looks like gold has been rising in reaction to a highly inflationary economy. Why else would a "safe haven" of value shoot up from under $300 to over $800 in a few short years?

This chart screams: somebody's lying or hallucinating. Either the U.S. Government is lying about the true rate of inflation, or gold buyers entered a 7-year state of hallucination. Which do you think is true? Gosh, that's a hard one. Of course the government is lying.

And yet there are certain technical features of this chart which suggest caution to those proclaiming $1,000/oz. gold, $2,200/oz. or $3,000/oz. gold. Maybe gold will shoot up to $3,000/oz.; this chart certainly depicts an unambiguous uptrend in gold.

Having noted that, let's also notice the divergences in DMI and volume, both of which are declining even as gold ran up in its recent parabolic rise. Could gold be setting up for a breather, or a serious retrace? Just as an opinion, not a prediction, I would say, hmm, why not? Nothing goes up in a straight line without occasional retraces.

But what if another trend is gathering force beneath the surface of gold's rise? That force is probably known to the majority of you, and it's called the devaluation of all "fiat" or paper currencies. What gold's rise might be telling us is the world's residents no longer trust any paper money as a reserve of purchasing power value.

Most of you also know that Republican Presidential candidate Ron Paul of Texas has proposed the radical idea (at least radical to the mainstream media) that the U.S. return to the gold standard, i.e. a currency backed not by promises but by gold. Most mainstream media sources dismiss this as a "lunatic fringe" notion. Yet not too long ago, the "lunatic fringe" idea was fiat money could be used to trade across borders for real goods.

Here is an extremely important essay from the pages of Foreign Affairs Magazine, (one of my regular reads), entitled The End of National Currency (May/June 2007, by Benn Steil, Director of International Economics at the Council on Foreign Relations and a co-author of Financial Statecraft.)

The author covers gold, international trade and fiat money succinctly, and then addresses a truly radical idea: a revival of gold money through private gold banks.

In other words: Forget government "fiat" currency, whether it's dollar, yuan, euro or yen--beneath the surface of the usual forex ups and downs, they're all trending down together. Forget trying to save essentially worthless paper money--store your wealth and transact your international business in private gold banks.

How would this work? The gold ETFs offer one pathway. Gold-backed exchange-traded funds (ETFs) have been accumulating physical piles of gold--hundreds of tons of the yellow metal. That is their promise: when you buy a share of a gold ETF, you're buying a sliver of actual gold, not a mining company or financial instrument like an option or derivative.

It doesn't take too much imagination to foresee an ETF accumulating, say, 500 tons of gold-- more or less the reserves of a small nation. Then the ETF launches the electronic equivalent of a currency--let's call them quatloos. (Hat tip to fellow Star Trek fans.)

So if I want to transaction some business internationally, in a currency with an assured value, I would deposit whatever fiat currency I had in hand into the ETF and then wire the gold-backed quatloos to my trading partner wherever the firm might be located geographically.

As all the globe's fiat currencies lose value, my quatloos would retain their purchasing power value everywhere in the world. Of course governments may well decide to confiscate their citizen's gold--as the U.S. government did in the mid-1930s--but if the bank is in Switzerland (for instance) and the transactions are all electronic transfers of quatloos, what exactly is there for our dear government to confiscate?

Of course I would use dollars in the U.S. and yuan in China for my daily living expenses, but my big holdings and business transactions would be made in quatloos, electronically.

Here are some excerpts from Mr. Steil's essay:

Capital flows were enormous, even by contemporary standards, during the last great period of "globalization," from the late nineteenth century to the outbreak of World War I. Currency crises occurred during this period, but they were generally shallow and short-lived. That is because money was then -- as it has been throughout most of the world and most of human history -- gold, or at least a credible claim on gold.

Funds flowed quickly back to crisis countries because of confidence that the gold link would be restored. At the time, monetary nationalism was considered a sign of backwardness, adherence to a universally acknowledged standard of value a mark of civilization. (emphasis added: CHS) Those nations that adhered most reliably (such as Australia, Canada, and the United States) were rewarded with the lowest international borrowing rates. Those that adhered the least (such as Argentina, Brazil, and Chile) were punished with the highest.

Yet what Polanyi considered nonsensical -- global trade in goods, services, and capital intermediated by intrinsically worthless national paper (or "fiat") monies -- is exactly how globalization is advancing, ever so fitfully, today.

Why has the problem of serial currency crises become so severe in recent decades? It is only since 1971, when President Richard Nixon formally untethered the dollar from gold, that monies flowing around the globe have ceased to be claims on anything real. All the world's currencies are now pure manifestations of sovereignty conjured by governments.

And the vast majority of such monies are unwanted: people are unwilling to hold them as wealth, something that will buy in the future at least what it did in the past. Governments can force their citizens to hold national money by requiring its use in transactions with the state, but foreigners, who are not thus compelled, will choose not to do so.

But the dollar's privileged status as today's global money is not heaven-bestowed. The dollar is ultimately just another money supported only by faith that others will willingly accept it in the future in return for the same sort of valuable things it bought in the past. This puts a great burden on the institutions of the U.S. government to validate that faith. And those institutions, unfortunately, are failing to shoulder that burden. Reckless U.S. fiscal policy is undermining the dollar's position even as the currency's role as a global money is expanding.

The precariousness of the dollar's position today is similar. The United States can run a chronic balance-of-payments deficit and never feel the effects. Dollars sent abroad immediately come home in the form of loans, as dollars are of no use abroad. "If I had an agreement with my tailor that whatever money I pay him he returns to me the very same day as a loan," Rueff explained by way of analogy, "I would have no objection at all to ordering more suits from him."

The question is how long such a well-managed fiat system can endure in the United States. The historical record of national monies, going back over 2,500 years, is by and large awful.

At the turn of the twentieth century -- the height of the gold standard -- Simmel commented, "Although money with no intrinsic value would be the best means of exchange in an ideal social order, until that point is reached the most satisfactory form of money may be that which is bound to a material substance."

Today, with money no longer bound to any material substance, it is worth asking whether the world even approximates the "ideal social order" that could sustain a fiat dollar as the foundation of the global financial system. There is no way effectively to insure against the unwinding of global imbalances should China, with over a trillion dollars of reserves, and other countries with dollar-rich central banks come to fear the unbearable lightness of their holdings.

So what about gold? A revived gold standard is out of the question. In the nineteenth century, governments spent less than ten percent of national income in a given year. Today, they routinely spend half or more, and so they would never subordinate spending to the stringent requirements of sustaining a commodity-based monetary system.

But private gold banks already exist, allowing account holders to make international payments in the form of shares in actual gold bars. Although clearly a niche business at present, gold banking has grown dramatically in recent years, in tandem with the dollar's decline. A new gold-based international monetary system surely sounds far-fetched. But so, in 1900, did a monetary system without gold. Modern technology makes a revival of gold money, through private gold banks, possible even without government support.

I recommend the entire essay; it is free online at the link above.

Thank you, S. B., ($40), for your generous contribution to this humble site. I am greatly honored by your readership and support. All contributors are listed below in acknowledgement of my gratitude.

Wednesday, November 14, 2007

Changing Tides III: Reversal of Wealth

The Standard Line of standard-issue financial analysts is that the great stock, bond and real estate bubbles--oops, I mean Bull Markets--have enriched everyone. This is the essential underpinning to the claim that we live in an era of "Great Prosperity."

Are there any reasons to be skeptical of this claim? Let's look at some charts. Based on data from the Wall Street Journal, most of the gains in the asset bubbles have accrued to the top 1%:

Roughly speaking, 90% of the wealth in the U.S. is owned by the top 10%. How dismissive of the bottom 40% is the financial media? Consider this excerpt from the latest issue of BusinessWeek: (11/19/07)

So far, the subprime mess is more of a human tragedy than a stopper for the economy. It's being felt most by the lower middle class, which isn't the driving force in economic growth. The bottom 40% of the population by income accounts for just 21% of consumer expenditures. Julia L. Coronado, a senior U.S. economist at Barclays Capital, says that in terms of spending power, and taking into account stock market gains, "Consumers haven't lost any wealth at all. In fact, consumers are better off than they were a year ago."

Make less than $46,000 household income? You don't count. You've been written off. And Ms. Coronado parrots the Standard-Issue line perfectly: the "folks that count"--those in the upper 40% of wage owners and earners--are much wealthier now because of the stock market boom.

Nice theory--but this seems to ignore the reality that the vast majority of the nation's wealth is owned by the top 1%, and most of the rest by the top 9%--not the top 40%. If we look at the chart on the right, we find that wages have been slipping for the past seven years--and that's using the government's horrendously understated /phony inflation numbers. If we calculated wages using real inflation (6-7%/year), wages have dropped considerably more than this chart suggests.

Let's take a look at a long-term chart of the Dow Jones Industrial Average (DJIA), courtesy of frequent contributor Harun I., and explore the idea that we're all much richer because of the market boom.

Just on first impression--this is obviously the chart of either a wildly inflated economy or a massive bubble of epic proportions--or maybe both.

(On a technical note: the Fibonacci projections indicated on the chart were computed from the 1903 lows which were the same as the 1932 lows to the 2007 highs.)

Does this chart look sustainable to you? Or should all those folks who are wealthy as a result of this amazing 25-year Bull market start looking for the exits?

If this is an economy with high inflation boiling away just beneath the surface, we might want to recall what happened the last time inflation ignited: that would be the Bear Market of 1966-1982 which wiped out 2/3 of all stock value via high inflation.

And if this is a massive stock market bubble, we might want to look at the Fibonacci projections to see where the market might retrace should the bubble deflate.

Interestingly, the first Fibo, 10,900 is smack dab in the middle of the 2000 dot-com era high. Note that this level offered resistance and support in the 2004-2006 period.

Notice how the DJIA swung between the next two Fibo projections, 8,800 and 7,200. In the 2002-2003 post dot-com Bear Interlude, the DJIA dropped down to 7,200, bounced back up to 8,800 and then double-bottomed near the 7,200 level before starting its ascent.

Way down at 5,500, the market briefly wobbled there before continuing it's dot-com bubble ascent.

In speculating about what might happen if this 25-year Bull Market reverses into an ebb tide /Bear Market, we could imagine a head-and-shoulders forming. The H&S is a standard pattern of technical analysis because markets tend to reach a "shoulder" or plateau of support and resistance, then break to new highs, after which they often return to the previous level of support--the first "shoulder"--thereby forming a second "shoulder." More often than not, they eventually break below the shoulder level and retrace to a lower level.

Could we have seen the top of this 25-year Bull Market? If so, perhaps--and this is merely an opinion, not a prediction--the 2000 dot-com era high at 11,000 would become the right shoulder of a slow decline back to the 7,200 level: yes, a 50% drop from the top.

So let's consider the standard financial analysts' favorite trope--that we're all so much wealthier now:

Here's another question for those happy-happy cheerleaders of ever-rising DJIA and ever-rising wealth for everyone: exactly how long do Bull markets last? Forever? The answer seems to be: about 20 years, in the very best of times. Here we are at 25+ years, having already over-stayed our welcome in Bull territory by five years.

And how long do Bear Tides tend to last? Looks like about 14 years. And so what happens to all that wonderful wealth everyone is always crowing about in the financial media in a 14-year Bear Market? Well, it recedes just like a tide, and people feel poorer because they are poorer. And not just us "written-off" lower-40% folks, but those folks at the top of the heap, too.

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Monday, November 12, 2007

Changing Tides I: Interest Rates and Bonds

Astute readers often request guidance on what we regular folk can do to weather the coming financial meltdown. For instance, here is Suzanne C.:

I read your essay on November 5th Empire of Debt I: The Great Unraveling Begins - very interesting and very enlightening. With all the turmoil going on in the markets, where would you invest money at this point? Things like gold and gas stocks have already gone up so much, but I don't want to stay in cash either. Your suggestions would be most appreciated."

Reader Than H. wrote:

I must tell you that I am gravely concerned at your predictions in your piece, "The Great Unraveling Begins". Is there anything that you can suggest the common man and woman can do to stem what I fear (but agree) will probably be many years of financial pain down the road?

Simply stated, are there any measures you might suggest that the non Wall Street billionaires among us can take to buttress ourselves from any coming economic storm that may be tracking our way? Do you foresee Great Depression like conditions? By your predictions, I am fearing that more and more, not that your piece was the first thing to shed a brutal light on reality, but just a further acknowledgment.

If you have any advice for readers like me, please let me know."

These are profound questions which I will do my best to cover. I am not qualified to offer specific investment advice, nor do I have any desire to do so, so please don't expect to find some simple homily here like "sink every last dime you have in silver." There is no simple answer to investing, for it depends on your personality, financial situation, appetite for risk, time-frame, etc.

But the financial markets do rise and fall much like the tides. If you pause on a beach for only a moment, you can't tell whether the tide is rising or ebbing; an occasional rogue wave might rise higher on the sand, falsely leading you to believe the tide is rising when in fact it is ebbing. Thus we have to take a longer view to see which way the tide is flowing.

In any market these tides are called trends. In an uptrend (Bull Market), you can buy just about any index or fund and make money. The same strategy in a downtrend will result in losses. The most important part of an investment strategy, then, it to get the trend right. If you get that wrong, then it's hard to maintain your purchasing power, i.e. keep up with inflation, never mind actually increasing your purchasing power.

For Instance: As the chart for the Dow Jones Industrials 1966-1979 in When "Buy on the Dips" Becomes a Pampers Moment revealed, your $1,000 invested in the DJIA in 1967 lost 2/3 of its value by 1982 when you account for the period's high inflation.

The DJIA essentially entered a trading range for 14 years, and if you held the index for that time period you lost 2/3 of your purchasing power, even as the index appeared to "hold its own" in nominal dollar terms. (Note I did not adjust for dividends; with those meager returns tossed in, the hapless "buy and hold" investor probably only lost 50% of their money in those 14 years.)

The financial markets appear to be entering a period of great volatility. The best that any of us can do--billionaires included--is get the primary trend right. In other words, there may be more frequent "wild swings" as the market participants try to ascertain if the primary trend is up (Bull) or down (Bear) in all sorts of markets: the dollar, U.S. stocks, emerging markets, gold and silver, commodities, petroleum, interest rates and bonds.

So where should we begin? Let's start with interest rates because if the tide has turned and cheap money is no longer freely available, then you can kiss housing and auto sales good-bye. And all other large consumer purchases, too.

Rising interest rates and the cut-off of "free and easy" borrowing would mean U.S. consumer spending (70% of the U.S. economy and 21% of the global economy) would plummet, rudely shoving the U.S. and the global economy into a deep recession.

Here is one of my favorite charts. If you care about trends, it is highly illuminating.

Before we dig into the chart above, let's note right away that the U.S. consumer saves less than nothing. Various cheerleaders have attempted to explain away this negative savings rate--the first such period since the Great Depression--by saying that 401K pension contributions aren't counted, and so on.

These are the usual cheerleader prevarications and obfuscations. Other nations in Asia and Europe have household savings rates in the 10% - 20% range--and they don't need fancy footnotes to explain the simple reality: U.S. households save less than nothing, while many other nations' citizens save prodigiously.

So why do we care? Here's why: foreigners have stopped buying U.S. debt. The latest U.S. government statistics reveal that the Chinese actually sold $10 billion in U.S. bonds last month, where for years (see green bars above) they were buying $10 billion or more a month.

What happens when nobody shows up to buy U.S. government and commercial/corporate bonds? The seller has to raise the yield to entice wary buyers. This is how the game worked up until recently. The U.S. ran a huge trade deficit with the rest of the world (roughly $750-$800 billion a year). Foreign governments took all these surplus dollars and bought U.S. Treasuries with the bucks, keeping U.S. interest rates low so the "junkie" (the spendthrift U.S. government and consumer who was borrowing heavily to buy consumer junk and fund an expensive war in Iraq) could continue buying their "cocaine" (consumer goods).

Unfortunately for the non-U.S. lenders, the U.S. has been playing an insidious game called "devalue the dollar." As the dollar has plummeted 37% since 2002, the non-U.S. owners of U.S. bonds have seen the purchasing power of their holdings slashed by 37%.

Multiply $3 trillion (guesstimate of non-U.S. ownership of U.S. Treasury and commercial debt) by 37% and you get, wow, $1 trillion in losses. Hey, a trillion lost here and a trillion lost there, and pretty soon you're talking real money.

Even as non-U.S. central banks are tiring of this charade, non-U.S. banks, pension funds and insurance companies are tiring of finding their "safe" U.S. mortgage-backed securities, CDOs and SIVs turning out to be worth 70%, 50% or even 0% of their original investment.

The U.S. investment banks have played 3-card monte with every sucker in the world, and now the suckers are drifting away in disgust.

Now take a look at the "long cycle" this chart reveals. Bond yields rise and fall in about 20-23 year cycles. Yields (and thus interest rates on mortgages, auto loans, etc.) topped out around 1982, and then fell until 2003. They have since started to rise.

Various bond pundits are predicting yields/rates will fall. This chart suggests they will be proven disastrously, horribly wrong. Interest rates don't drop for 21 years and the stay flat for another 20 years; historically, they rise.

Let's turn to a chart provided by frequent contributor Harun I. awhile back. Note that the value of any long-term bond rises as the yield drops and falls as the yield rises. Thus the value of the Treasury bonds dropped to all-time lows when interest rates hit 15% in 1981, and they rose all through the 2000-2004 period as interest rates fell.

Without belaboring the point, here's how this works. If you buy a 10-year Treasury (or corporate bond) tomorrow which pays 5%, what happens if interest rates rise to 10%? Who wants a lousy bond paying a lousy 5%? Nobody. The face value of that bond falls by 50%, down to the point that the effective yield is 10%. This is why rising interest rates absolutely devastate the bond market.

In summary: we have glib pundits predicting low or even dropping interest rates forever, but they will be proven terribly wrong. Why? Because the U.S. banks and government have ripped off non-U.S. investors to the tune of trillions in losses, via a sharp devaluation of the dollar and via "marked to model/myth" garbage debt packaged and sold as "safe" investments.

Non-U.S. entities are now net sellers of dollar-denominated debt, and you have to wonder what took them so long. The Big Con suckered them in, and now they are suffering stupendous losses. Do you really agree with the bond cheerleaders that non-U.S. bankers and investors are dumb enough to trust any U.S. security ever again? Maybe in 20 years.

There are potential saviors: U.S. pension and insurance companies. Frequent contributor Albert T. has suggested that these U.S. financial institutions have the assets in hand to buy U.S. Treasuries and corporate bonds as foreign entities sell. He may be proven correct in this; but I have some doubts, based on the inflation rate.

As I have covered ad nauseum here before, actual inflation is running about 6-7% annually, if not more. If you're a fund manager, and you buy a 20-year bond paying 5%, then you're losing 2% a year in real terms. Can you do that and keep your job? I don't see how you can--you're losing money every year. You might buy the bond on a gamble that yields will fall to 4%, but if you're wrong and they double to 10%, you'll take a 50% haircut-- a catastrophic loss for a "safe" investment.

The historical cycle--the tide, if you will--is running against the cheerleaders and optimists. The tide has turned, and interest rates are rising, and will contiue to rise for at least another 15 years.

OK, so the Fed has briefly run yields down; but if nobody buys their lies about low inflation, then who will be stupid enough to guarantee losses for decades to come by buying a low-yield bond or mortgage-backed security or corporate bond? No one.

That's how we get interest rates and yields rising for the next 15 years, folks; the U.S. bankers have conned the world with bogus MBS, CDOs and SIVs, while the Fed and Treasury have shredded non-U.S. holders of U.S. debt with an "incredibly shrinking" dollar.

When nobody steps up to buy the risky debt at 5%, then you have to raise rates regardless of what the U.S. mortgage, commercial paper and credit card lenders are screaming about.

There are a couple of other problems. If U.S. pension funds and other institutional investors lose a few trillion in the current market meltdown, they may not have any free cash to invest in new U.S. debt. There may be few buyers of low-yielding debt. Nobody seems to think this is possible, which is a good reason to think it might.

Ironically, a sharp rise in U.S. interest rates would immediately support the dollar. Buying euros in 2002 when $1 = 1.15 euros was a brilliant idea. Buying euros now when $1 = .69 euros--maybe that's not a sure bet any more.

Bottom line: if you think the tide has turned and interest rates will rise for years to come, then you would not be interested in buying long-term Treasury, mortgage or corporate debt. If you agree with the cheerleaders, that interest rates are sure to fall and stay low for years or even decades to come, then you'd buy long-term debt with abandon.

Here's the truly frightening part of the above chart: note that Harun's projection for the possible head-and-shoulders pattern actually exceeds the 1981 low. THis opens the door, figuratively speaking, to the possibility that rates will rise higher than the 16% peak reached in 1981.

Don't think that's remotely possible? Neither did anyone in 1970. The low interest rates of the 60s were supposed to last forever, too, but they didn't; the tide turned, and the pundits and cheerleaders were too busy congratulating themselves to notice.

Thank you, Dineshkumar P. ($10) for your generous contribution to this humble site. I am greatly honored by your readership and support. All contributors are listed below in acknowledgement of my gratitude.

Saturday, November 10, 2007

Longtime contributor U.K.C. sent in this timely quote from John Kenneth Galbraith's classic bookThe Great Crash 1929 :

"A common feature of all these earlier troubles was that having happened, they were over. The worst was reasonably recognizable as such.

The singular feature of the great crash of 1929 was that the worst continued to worsen. What looked one day like the end proved on the next day to have been only the beginning. Nothing could have been more ingeniously designed to maximize the suffering, and also to insure that as few as possible escaped the common misfortune.

The fortunate speculator who had funds to answer the first margin call presently got another and equally urgent one, and if he met that, there would be still another. In the end, all the money he had was extracted from him and lost. The man with the smart money, who was safely out of the market when the first crash came, naturally went back in to pick up bargains...

The bargains then suffered a ruinous fall. Even the man who waited out all of October and all of November, who saw the volume of trading return to normal and saw Wall Street become as placid as a produce market, and who then bought common stocks, would see their value drop to a third or a fourth of the purchase price in the next twenty-four months. The Coolidge bull market was a remarkable phenomenon. The ruthlessness of its liquidation was, in its own way, equally remarkable... "

Frequent contributor azvitt took this line from yesterday's post: The fear and distrust can no longer be papered over with more lies and prevarications.

and commented: Considering the scale of this financial diarrhea, perhaps it might be said that it "can no longer be pampered over"?

(Grin)

OK, chart time. Here are two charts depicting the last two post-bubble "echo bubbles" which led to declines of around 45% - 50% in the Dow Jones Industrials. Looks like we're right there again. So when the markets "rally" and fail, and then "rally again," remember what these charts suggest: "echo bubbles" have historically fallen 40+%, not a meager 10%:

When the cash value of an account falls below 50%, the broker issues a margin call. The owner either has to pony up more cash to cover the call or sell stocks to raise the cash value of the account back over 50%.

This has a very nasty corrollary: you have to sell $2 to raise $1 in cash. If you have a $100,000 account with $50,000 on margin, and the account falls to $90,000, then you will get a margin call of $10,000. To raise $10,000 in cash, you will have to sell $20,000 of stock.

Margin calls have to be covered within three trading days. The decline kicked off in earnest on Wednesday, Nov. 7, so folks with margin calls will have to transfer cash into their accounts or sell stock/securities on Monday, Nov. 12 or Tuesday Nov. 13. Thursday's decline resulted in additional margin calls.

In the past five years of debt-fueled "prosperity," in most cases the market Bulls "saved" those facing margin calls by engineering rallies after every one or two-day decline. But now it seems the era of miraculous "last hour rallies" may have drawn to a close.

More margin calls are being issued at the close of every day. Next week, the margin chickens come home to roost. As selling generates more margin calls, then those with huge margin calls must sell, accelerating the decline, which then forms a negative feedback loop of great power: more selling begets more margin calls which beget more selling.

2. the yen carry trade is toast. The yen carry trade (borrowing in yen and investing dollars in U.S. stocks and bonds) has been one of the fundamental supports of the U.S. market's five year rally. Now that the dollar is collapsing, foreign exchange money is flowing into the yen, strengthening that currency to the 110 level. Although I am not an expert in this trade, there seems to be a "line in the sand" around 115; below that, the trade gets riskier and traders "unwind" their trades by selling U.S. stocks and converting the dollars back into yen.

Combine the unwinding of the carry trade with margin calls, throw in the loss of confidence in the dollar, the Fed and the U.S. financial markets and bankers, and you have sufficient ingredients to bring about a 40% decline. I know, I know--that isn't possible. The Fed will save us, or Hank Paulson's Plunge Protection Team, or some sudden splash of "good news" engineered by the lapdogs of the financial media.

As many others have noted, the Fed can't cut the Fed Funds Rate any further without risking a global currency crisis. Frequent contributor U. Doran sent in the very important story that French President Sarkosy (who is generally pro-American) is warning Bernanke & Co. not to try to "save" the U.S. by devaluing the dollar:

The French president, Nicolas Sarkozy, has warned the United States Congress that the US risks triggering "economic war" if it attempts to devalue its way out of trouble by allowing a relentless slide in the dollar.

(Note that this important story received virtually no coverage in the U.S.-based mainstream or financial media. This reflects the hubris and arrogance at the very heart of U.S. financial markets and policies.)

Before you count on all those wonderful, warm and fuzzy fantasies of being saved by yet another miraculous Bull Rally, recall that $3 trillion trades on the forex each and every day. Even if central banks intervene to the tune of tens of billions of dollars, trying to weaken the yen and prop up the dollar, the juiced rally will only last as long as the intervention.

Perhaps the moment has finally arrived when all the men (and a very few women) behind the curtains, furiously pulling their levers to control the markets, may find their levers have limits.

Readers Journal updated 11/09/07 More new entries-- Please see top-right sidebar for this month's essays.

Thank you, Sourav G. ($10) for your generous contribution to this humble site. I am greatly honored by your readership and support. All contributors are listed below in acknowledgement of my gratitude.

Friday, November 09, 2007

Behind the Curtain III: The Destruction of Trust

Let's start by reprinting a chart of the "fear index" a.k.a. the VIX which I ran on Monday, Nov. 5. (note the chart was dated 10/30/07, from the week before.) I wrote that the chart suggested a sharp market decline was highly probable. Voila, as the French say:

I received several emails from annoyed Bulls and other doubters after posting this chart, one demanding to know what my own market positions were, i.e. was I walking the walk or just talking the talk. It was a fair question, so I politely informed the affronted Bull that I had strike 54 puts on the QQQQ (Nasdaq 100) and strike 60 puts on APC (Anadarko Petroleum). The first position has done well and I suspect the second position will do well by the end of next week.

OK, I was lucky. But the VIX was shouting a warning to the Bulls. Now we see the 20-day moving average has crossed up through the 50-day moving average, a bullish cross. (Recall that the VIX rises as the markets declines, so a Bullish VIX means the stock market is diving/Bearish.) Also note the positive MACD and strong RSI (relative strength). Anyone thinking the Bulls are going to rise up and re-take the market by storm would be wise to consider the full meaning of this chart.

Which is what? (Drum roll please): the destruction of trust.

Fed Chairman Ben Bernanke testified to Congress yesterday (Thursday 11/8/07) that the U.S. economy was "resilient" and he wasn't worried about the Chinese central bank selling dollars. The markets tried to rally on his usual threadbare lies and then tanked.

Mr. Bernanke, you have zero credibiity. You spout absurd reassurances based on rigged statistical lies, and the world no longer believes anything you say. You have sold your soul to Wall Street for a pittance and thrown away whatever credibility you once had.

And Ben isn't the only one who has thrown their credibility to the winds in an endless spew of outlandish, pathetically brazen lies; all of Wall Street has mouthed the same empty slogans of "containment" and "resilience" and now nobody trusts them, either.

Every time you turn around, another "trusted big name on Wall Street" has reluctantly copped to another $3 billion in losses--after reassuring us via the lapdogs in the financial media that they were not reporting any write-downs.

Or reporting write-downs were now somewhere between $8 billion and $11 billion. You mean you don't know? Now we know that "between $8 and $11 billion" really means between $20 and $50 billion, depending on just how honest they're forced to be.

But the Lying Bulls are still hoping to pull a fast one in order to save their billion-dollar bonuses this year. Frequent contributor Zeus Y. sent in this note quoting Eric Janzen over at the well-regarded iTulip website: (subscription required for some content)

Thought you'd like this blurb to see how banks and fund managers are trying to eke out a few more months of delusion, in particular: "Ronald C. Ward, President of fund of hedge funds FutureSelect Porfolio Management, for example, told us in a recent interview that fund managers were going to try to keep stock funds up for end of year bonuses, if possible. With more than 50% of equity market capital at their disposal, success was within reach so the effort was at least worth a try. (emphasis added, CHS)

Everyone else in the business we talked to was similarly skeptical that a narrow run in the stocks of exporting companies could sustain the market. So we called in our wayward readers to make sure they had not lost sight of the unreality around them. Today, with the DOW plunging 360 points, they don't need us to remind them.

So what rushes into the vacuum left as trust in our financial leaders and institutions evaporates under the hot relentless wind of lies? Fear.

That's what the VIX is reflecting: the fear of trust demolished. When you have lost all trust in those entrusted with guiding the nation's economy and currency, then fear is natural. When the institutions you have entrusted your money to are all lying, loudly, aggressively, defensively, then eventually you realise you have no choice but to sell: sell your stocks, sell your bonds, sell your emerging markets funds, sell it all because you can no longer trust those who have thrown their credibility away in a blinding blizzard of carefully engineered obfuscation and lies.

Now who do you trust? The foaming-at-the-mouth Bulls on financial television? How much will you have to lose before you turn the shills off? Maybe there's nobody left to trust except a very few on the margins of the media, and those analysts who write blogs.

I promise you the real firestorm has not yet ignited. I will cover this in more depth next week, but here is the reality Mr. Bernanke, Wall Street and the financial media are too terrified to ever mention:

All the garbage debt which investment banks are writing off is merely the tip of an incredibly massive iceberg. The bulk of that garbage debt is held by pension funds, insurance companies and other institutions. These institutional buyers are generally prohibited from owning "risky assets," i.e. any debt instruments rated less than AA.

So what happens when the rating agencies finally face reality and lower the rating on all that AA debt to BB or lower? The institutions are required by their own bylaws to sell the garbage. And what happens when hundreds of billions of dollars in downgraded debt is thrown onto a market gripped by fear of risk? The already-low market price of these "assets" falls--and keeps falling until many are written off as entirely worthless.

Don't think it will happen? Sure the market will recover because the fund managers are crying for their bonuses? Keep watching, for it's beyond their control now; the fear and distrust can no longer be papered over with more lies and prevarications.

Thank you, U.K.C., ($50) for your continued support and encouragement both financially and in the realm of powerful ideas. I am most appreciative of your donation to this humble site, and greatly honored by your readership. All contributors are listed below in acknowledgement of my gratitude.

Thursday, November 08, 2007

Behind the Curtain II: The Destruction of the Dollar

The dollar drop seems to be gathering speed. Many have been predicting the decline of the U.S. dollar would continue, but the speed of its recent decline is frightening to everyone but Ben Bernanke and Hank Paulson--the two people who should not just be worried but who should be acting to arrest the decline.

Anyone with a moderate serving of common sense knows what needs to be done: Mr. Bernanke needs to stand up and announce that there will be no Fed Fund rate cuts in December and beyond, as the U.S. is finally going to defend its currency.

Why should we care? It's called a vast reduction in the purchasing power of everyone paid in dollars. Oil exporters are paid in dollars, and in reaction to the reduction of value of those dollars the price of oil has jumped. Thanks to frequent contributor Harun I., we have a chart which displays this:

But the U.S. Dow Jones Industrial Average (DJIA) just hit all-time highs; doesn't that mean that we're all making money and the nation is doing just peachy-keen fine? Not if you look at the Dow/gold ratio. Harun was kind enough to provide this chart of the Dow and gold plotted in a ratio.

Here's how this works. At real Bear Market lows, such as 1980-81, the ratio is 1, as the Dow was at 800 and gold was $800 per ounce. At the peak of the dot-com bubble, the ratio had soared to 45. Put another way: one share of the DJIA bought 45 ounces of gold. Back in 1980, it bought one ounce of gold. Currently it buys about 16, a loss of 2/3 since 1999. So much for "new Dow highs."

Harun plotted some Fibonacci projections on the chart, and this suggests the Dow/gold ratio might descend to 6--meaning the Dow might stabilize at 12,000 and gold will rise to $2,000, or gold might stabilize at $1,000/ounce and the Dow will drop to 6,000.

Harun made these comments about the chart:

Despite the recent euphoria the Dow/Gold ratio is testing old lows. Understand that the Dow is at a higher price than it was in 2006 and therefore has lost much more value. The 12 month Rate of Change is in negative territory at 12% less than it was 12 months ago.

I am not an Elliot Wave expert but if the next leg down occurs it will most likely be a 3rd wave which tends to be the longest. And there is no real support until 9.

100% projection takes us down just above 6. That would represent an approximate loss of 86% of the Dow's purchasing power relative to Gold. The relation to commodities would be similar.

The reality is owners of U.S. stocks have seen the real value/purchasing power of their holdings decimated. Thank you, Hank and Ben, for destroying our currency to save your banker buddies.

The Ministry of Propaganda has been working overtime to reassure us all that $100/barrel oil is "no problem." Like rank weeds popping out after a rain of doubt, suddenly the mainstream media is chockful of stories claiming $100/barrel oil will have virtually no effect on the "diversified, resilient U.S. economy." Various charts are trotted out to prove that the rising cost of energy will have no adverse effects.

So next time you pull into the gas station, just fold up a chart from the Wall Street Journal and insert that in your tank. Maybe your vehicle's engine will muster up sufficient belief in the "diversified, resilient U.S. economy" to keep running despite the absence of fuel.

The Ministry of Propaganda's most important Big Lie is that there is no inflation. How the MP will manage when oil is $120 and gasoline is $4+ a gallon is a real mystery.

Meanwhile, back in the U.S. stock market, money managers desperate to maintain some percentage of their clients' purchasing power are chasing technology stocks higher and higher. There are supposedly so many oil tankers clogging Rotterdam harbor that they can't even offload their cargoes. Hmm. Perhaps the rise in oil is not demand-driven but just another desperate speculative rush to anything but the dollar.

Ironically, the smart money fleeing the U.S. stock market may be exacerbating the dollar's decline. Those in the know have watched the heavy buying of U.S. Treasuries recently and wondered who the heck is buying Treasuries even as the Chinese and other non-U.S. holders have started to dump their dollars. The answer appears to be managers selling their U.S. stocks and putting the money into "safe" Treasuries.

As long as there are fools willing to buy Treasuries, the U.S. Treasury is under no pressure to raise interest rates. The buyers must be domestic, because foreign buyers of Treasuries are losing money hand over fist as the dollar loses more value every day. Thus a stock market meltdown in the U.S. might have the peculiar consequence of encouraging the dollar's continued slide as frantic U.S.-based portfolio managers seek a lousy 4% return rather than suffer gigantic losses in U.S. stock markets.

From the point of view of foreign owners, however, the Treasuries are handing them catastrophic losses on a daily basis. Thus we have the Chinese central bankers issuing unveiled warnings that the U.S. had better start defending the dollar lest its bagholders decide to exit the dollar en masse.

Unfortunately for the Chinese, Ben and Hank only have ears for their pals on Wall Street. The rest of the world gets a deaf ear. You just lost 10% of your dollar portfolio's value? Too bad; we have to protect our poor little crying friends over at Morgan Stanley, Citicorp, Merrill Lynch, Bear Stearns and Goldman Sachs.

All of this makes me wonder if all markets--even those in gold and oil--might not suffer simultaneous collapses. Just from a common-sense perspective, you have to notice that all markets are at extremes: global stock markets, global real estate markets, global petroleum markets and precious metals. So-called "safe havens" are skyrocketing in parabolic rises which usually end in sharp collapses. Could speculative unravelings eventually even reach oil and gold?

Given that the paper trading in those markets far exceeds the physical supply's value-- why shouldn't they suffer the same speculative collapse as any other market perched at extremes? If derivatives, futures contracts and options far exceed the actual physical commodities' value, then what happens when speculators have to liquidate positions to cover margin calls or derivative unwindings elsewhere?

Even if there are no direct links between these markets, the major players own financial instruments in all markets. As players unwind positions in one market, they might have to sell in another market to cover client withdrawals or other liabilities. Perhaps that's how a meltdown in one apparently isolated market could quickly infect every market at speculative extremes--which is all markets, everywhere.

Google ads don't work update: I received a number of emails from readers which represent a cross-section of experiences with Google ads:

Kip S.

I'm sure that this will be one of many emails, but I used Google Advertising (via keywords matching) for several months. All I can say is that I had zero success with them.

They also used (use?) an auction process for page placement -- so for a top placement on a search page it can be quite expensive (even for something as narrow as "Music Lessons -- My City CA). At least you don't pay unless there is a click thru.

The stock is practically parabolic, but from my (very limited) experience, they are not very useful.

Tom B.

You're not alone. I almost never click on the ads, and when I do, I'm usually disappointed. I've never understood why people feel they *must* advertise there.

I thought Google was the coolest thing ever, back when it first supplanted AltaVista. But though I still use Google search every day, and Google maps pretty often, I refuse to put my whole life in Google's hands - no Gmail or any of the rest.

Shawn S.

One more point in reference to your Google post. When you start a new ad campaign they "by default" sign you up for their "content network" which serves your "targeted" ads on thousands of worthless sites with webmasters clicking on their own ads to generate revenue. You then have to go through numerous buried pages (Google help staff will not assist you to do this) in order to disable this "feature" and only get the targeted search ads you want. A great scam.

Matt N.

Hey charles about the google ads. If you are an advertiser you only pay for what people click on. For example the fact my ad shows on your page one million times and is never clicked, well I dont pay at all. I only pay per click, thats the whole idea behind adwords. Its actually up to google to put my ads in places people click on them, its a waste for them if people don't. I pay like 5 cents per click, adwords also tracks how many clicks per sale. You put some code on the after checkout screen and it tracks sales vs clicks. So you can see upfront if its profitable for ya.

I never experienced any fraud, we were getting a sale for every 20 clicks or whatever. The product didnt have much profit margin, so we had to drop some words from the campaign. If the product had a high profit margin and you were getting a sale for every 20 clicks, well it would seem like a good deal to me. forgive me if you already knew this, just reading the article thought I would toss it out. Keep up the good work--

Thank you, readers, for sharing your experiences.Note: I have no position long or short in Google or any other web advertising firm.

Thank you, David R., ($5) for your thoughtful and much-appreciated donation to this humble site. I am greatly honored by your support and readership. All contributors are listed below in acknowledgement of my gratitude.

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